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How to Choose the Perfect Business Entity for Your Venture
Choosing the right business entity is a critical decision for entrepreneurs and business owners. The type of entity you select can have significant implications for liability, taxation, and the overall management of your business. In this article, we will explore the pros and cons of various business entities, including sole proprietorships, partnerships, limited partnerships, limited liability companies (LLCs), C corporations, and S corporations which are the most common business structures. We will also discuss liability issues, self-employment taxes, owner limitations, taxation, formation, and dissolution for each entity type.
The business structure one chooses influences everything from day-to-day operations to taxes and how much of their personal assets are at risk. One should choose a business structure that provides the right balance of legal protections and benefits.
GENERAL OVERVIEW OF COMMON BUSINESS STRUCTURES | |||
Business structure | Ownership | Liability | Taxes |
Sole proprietorship | One person | Unlimited personal liability | Self-employment tax Personal tax |
Partnerships | Two or more people | Unlimited personal liability unless structured as a limited partnership | Self-employment tax (except for limited partners) Personal tax |
Limited liability company (LLC) | One or more people | Owners are not personally liable | Self-employment tax Personal tax or corporate tax |
Corporation - C corp. | One or more people | Owners are not personally liable | Corporate tax |
Corporation - S corp. | 100 people or fewer can include certain trusts and estates. But no partnerships, corporations, or non-resident aliens | Owners are not personally liable | Personal tax |
Corporation – B corp.* | One or more people | Owners are not personally liable | Corporate tax |
Corporation - Nonprofit* | One or more people | Owners are not personally liable | Tax-exempt, but corporate profits can’t be distributed |
* Further information about B corporations and B- corporations not included in this material.
Compare general traits of these business structures, but remember that ownership rules, liability, taxes and filing requirements for each business structure can vary by state. The following material is a general overview of these business structures and it is best practice to consult with your legal counsel and this office before making a final decision.
Sole Proprietorship – A business is automatically considered to be a sole proprietorship if it is not registered as any other kind of business. Thus, the sole proprietor’s business assets and liabilities are not separate from personal assets and liabilities. As a result, sole proprietors can be held personally liable for the debts and obligations of the business. A sole proprietor may also find it difficult to raise money since banks are hesitant to lend to sole proprietorships.
NOTE: If the business owner is the sole member of a domestic limited liability company (LLC) and elects to treat the LLC as a corporation, then it is not a sole proprietorship.
Pros:
o Simplicity and Cost-Effectiveness: Sole proprietorships are the simplest and least expensive business entities to establish. They require minimal paperwork and are easy to manage.
o Complete Control: A sole proprietor has full control over all business decisions and operations.
o Tax Benefits: Income and expenses are reported on the individual’s personal tax return, simplifying the tax process. The sole proprietor may also qualify for certain tax deductions available to small businesses.Cons:
o Unlimited Liability: Sole proprietors are personally liable for all business debts and obligations, which means personal assets are at risk if the business incurs debt or is sued.
o Limited Growth Potential: Raising capital can be challenging, as a sole proprietorship cannot sell stock or bring in partners.
o Self-Employment Taxes: Sole proprietors are responsible for paying self-employment taxes, which cover Social Security and Medicare contributions.Formation and Dissolution:
o Formation: Establishing a sole proprietorship is straightforward, often requiring only a business license or permit.
o Dissolution: Dissolving a sole proprietorship is equally simple, involving the cessation of business activities and settling any outstanding debts.
Partnership - A partnership is the relationship between two or more people in a trade or business together. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business. Partnerships represent the simplest structure for two or more people to be in business together. Two of the most common types of partnerships include:
Limited Partnerships (LP): Which have one general partner with unlimited liability. The other partners have limited liability and generally have limited control over the business.
Partnerships are pass-though entities, meaning the partnership does not pay taxes. Instead, income, losses, credits and other tax issues are passed through to the partners in proportion to their partnership ownership and reported on their individual returns.Limited Liability Partnerships (LLP): A limited liability partnership is also a pass-through entity. The only difference is all the partners have limited liability from debts of the partnership, and the actions of other partners.
Pros:
o Shared Responsibility: Partnerships allow for shared management and financial responsibility, which can ease the burden on individual partners.
o Flexibility: Partnerships can be structured to suit the needs of the partners, with varying levels of involvement and profit-sharing.
o Tax Advantages: Partnerships are pass-through entities, meaning profits and losses are reported on the partners' personal tax returns, avoiding double taxation.Cons:
o Joint Liability: In a general partnership, each partner is personally liable for the debts and obligations of the business, including those incurred by other partners.
o Potential for Conflict: Disagreements between partners can arise, potentially leading to business disruption.
o Self-Employment Taxes: Partners who aren’t limited partners must pay self-employment taxes on their share of the profits.Formation and Dissolution:
o Formation: Partnerships are formed through a partnership agreement, which outlines the terms of the partnership, including profit-sharing and management responsibilities.
o Dissolution: Dissolving a partnership requires settling debts, distributing assets, and notifying relevant authorities.
Limited Liability Company (LLC) -A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, and those considering an LLC should check with the state before starting a Limited Liability Company. A business must register with the state and pay LLC fees to become an LLC.
Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner. Generally, banks and insurance companies cannot be an LLC, and generally there are special rules for foreign LLCs.
Pros:
o Limited Liability: LLC owners, known as members, are protected from personal liability for business debts and obligations.
o Flexible Taxation: LLCs can choose to be taxed as a sole proprietorship, partnership, or corporation, providing flexibility in tax planning.
o Operational Flexibility: LLCs have fewer formalities and regulations compared to corporations, allowing for flexible management structures.Cons:
o Regulations: LLCs are subject to varying state laws, which can complicate operations if the business operates in multiple states.
o Self-Employment Taxes: Members may be subject to self-employment taxes on their share of the profits.
o Cost: Forming and maintaining an LLC can be more expensive than a sole proprietorship or partnership due to state filing fees and annual reports.Formation and Dissolution:
o Formation: LLCs are formed by filing articles of organization with the state and creating an operating agreement.
o Dissolution: Dissolving an LLC involves filing dissolution documents with the state and settling any outstanding obligations.
C Corporation - A corporation is a legal entity that's separate from its owners. Corporations can make a profit, be taxed, and held legally liable.
Corporations provide strong protection to its owners from personal liability, but the cost to form a corporation is higher than other structures.
Unlike sole proprietors, partnerships, and LLCs that are pass-through entities, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice. This happens when the corporation distributes profits to its shareholders in the form of dividends which are taxable to shareholders on their personal tax returns.
Corporations have a separate life from its shareholders. Corporate ownership is in the form corporate stock which can be purchased and sold without disturbing the corporation.
Ownership in the form of stock gives corporations the advantage of being able to raise capital through the sale of stock, and employee stock options can be a benefit in attracting employees.
Pros:
o Limited Liability: Shareholders are protected from personal liability for corporate debts and obligations.
o Unlimited Growth Potential: C corporations can raise capital by issuing stock, making them attractive to investors.
o Tax Advantages: Corporations can benefit from various tax deductions and credits not available to other entities.Cons:
o Double Taxation: C corporations face double taxation, where profits are taxed at the corporate level and again as dividends to shareholders.
o Complexity and Cost: Corporations require more formalities, including a board of directors, bylaws, and regular meetings, which can be costly and time-consuming.
o Regulatory Requirements: Corporations are subject to stringent regulatory requirements and reporting obligations.Formation and Dissolution:
o Formation: C corporations are formed by filing articles of incorporation with the state and creating corporate bylaws.
o Dissolution: Dissolving a corporation involves a formal process of liquidating assets, settling debts, and filing dissolution documents with the state.
S Corporation -S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S corporation status, the corporation must meet the following requirements:
Be a domestic corporation
Have only allowable shareholders
o May be individuals, certain trusts, and estates and
o May not be partnerships, corporations or non-resident alien shareholdersHave no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
To become an S corporation, the corporation must submit Form 2553, Election by a Small Business Corporation signed by all the shareholders.
Pros:
o Limited Liability: Like C corporations, S corporation shareholders are protected from personal liability.
o Pass-Through Taxation: S corporations avoid double taxation by allowing income, deductions, and credits to pass through to shareholders' personal tax returns.
o Tax Savings on Self-Employment: Shareholders can receive a salary and dividends, potentially reducing self-employment taxes.Cons:
o Ownership Restrictions: S corporations are limited to 100 shareholders, and all must be U.S. citizens or residents.
o Complex Formation and Maintenance: S corporations require adherence to strict IRS requirements and ongoing compliance with corporate formalities.
o Limited Flexibility in Profit Sharing: Profits and losses must be distributed according to share ownership, limiting flexibility in profit-sharing arrangements.Formation and Dissolution:
o Formation: S corporations are formed by filing articles of incorporation and electing S corporation status with the IRS.
o Dissolution: Dissolving an S corporation involves liquidating assets, settling debts, and filing dissolution documents with the state and IRS.
Choosing the right business entity is a crucial decision that can impact your business's success and your personal financial security. Each entity type offers distinct advantages and disadvantages, and the best choice depends on your specific business goals, risk tolerance, and financial situation. It's essential to consult with legal and financial professionals to ensure you select the entity that aligns with your long-term objectives and provides the most benefits for your business. It most likely is appropriate to consult with this office to go over other relevant issues before making the choice.
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